Founders and Advisors

Vol. 2,No. 7

Jean L. Batman

Jean L. Batman founded Legal Venture Counsel, Inc. in 2004 to provide outside general counsel services to investors, entrepreneurs, and small businesses. Prior to forming Legal Venture Counsel, Ms. Batman was a Partner in the San Francisco offices of Duane Morris LLP, one of the country’s 100 largest law firms. As outside general counsel to a variety of companies and individuals, Ms. Batman provides business and financial legal services to privately held entities operating in a broad range of industries including real estate development, financial and professional services, manufacturing, software, retail, biotechnology/specialty pharmaceutical, and high technology.

From Advising the Small Business, Chapter 9

Find out how venture capitalists determine who is a founder.

Find a sample founders agreement at the end of the article.

What Is a Founder?

There is much confusion over what makes someone a founder, and whether it has any legal significance. A founder is really nothing more than a designation that the original promoters of an idea bestow on one another to identify to the outside world who is credited with getting the company off the ground. Often, a key hire may come in well after the company has been formed and in the end be described as a founder.

The expression has no legal significance per se. However, venture capitalists (VCs) do distinguish founders from other employees for certain reasons. For example, VCs often require the founders to make certain representations and warranties individually at the time of the first round of investment. In addition, VCs might want to impose certain vesting restrictions on the stock of founders, but not be so concerned with the other employees on the theory that the founders really constitute the brain trust. (Nonetheless, late hires, especially late executive management hires, are often treated like founders by VCs for such purposes).

When Should Founders Have a Written Agreement?

In some cases, it will make sense for the founders of a new venture to have a written agreement even before they form the entity in which they ultimately intend to pursue the enterprise. This is because if they begin jointly pursuing the new venture for a period of time before forming an entity, they will have entered into a general partnership and will be governed by the default rules for such enterprises unless they reduce the terms of their relationship to writing. See Chapter 8, Organizing or Cleaning Up a Partnership.

What Is Founders Stock?

Founders of companies often make the mistake of waiting until they have received a strong indication of interest from an investor before they incorporate and issue their stock. Forming a company too close in time to raising capital can create a significant tax issue. Specifically, if founders issue themselves stock at the time of formation for $.01 per share (for example) and then within a short period of time, outside investors pay $1.00 or more per share (for example), it might appear upon an IRS audit that the founders issued themselves stock at significantly below the fair market value per share. The difference between what the founders paid for their stock, and the fair market value of that stock based on the sale to outside investors, may be characterized as compensation income resulting in what could be significant tax liability to the founders. If, on the other hand, founders stock is issued long before investor commitment, and certain significant milestones are achieved in the interim, this risk decreases substantially.

The earlier stock is issued, the earlier the capital gains period begins to run. Upon a liquidity event, stock that has been held for one year or more will be taxed at the capital gains rate, which is currently 20 percent. Gains on stock held for less than one year are taxable at an individual’s ordinary income tax rate, which can be significantly higher than the capital gains tax rate.

How Many Shares Should Founders Receive?

As discussed in Chapter 6, the total number of authorized shares, and the total number of issued and outstanding shares, at the time of formation of the company is largely arbitrary, and in the end not of high importance. What really matters is the relative allocation of the equity among the founders. The numbers of shares authorized and outstanding can be, and often are, adjusted upward through stock splits. Notwithstanding this, there are a couple of guiding factors.

Prospective hires often focus more on the total number of shares awarded to them (either outright as restricted stock or by the grant to them of options to purchase the shares) rather than the percentage of the company that such shares represent. As a result, the company should consider putting in place an equity incentive plan that has a significant number of shares, often between 1,000,000 and 2,000,000 shares. At the high end of the range, this will allow the company to make awards in the market range in terms of both percentage and raw numbers (i.e., 2 to 3 percent for a vice president of business development, at 50,000 to 70,000 shares). In addition, this plan allows the company to establish a low issuance price (in the case of restricted stock) or exercise price (in the case of options).

Venture capitalists often have an opinion about the number of shares of common stock that should be issued and outstanding at the time of their investment. They usually run numbers around an assumed purchase price in the range of $1.00 per share for a first or “Series A” round. Some VCs are more concerned about the initial purchase price than others, and their input will dictate what the capital structure of the company looks like. For sake of discussion, if we assume that a VC firm is going to put $5 million into a company with a pre-money valuation of $5 million, and require a 20 percent employee pool, that would translate to an employee pool with 2,000,000 shares.

The issuance of stock among the founding group is a determination to be made among the founders. The decision is typically based on relative contributions to the formation of the company, including the conception of the idea, leadership in promoting the idea, assumption of risk to launch the company, sweat equity, writing of a business plan, and development of any underlying technology. In addition to preformation contributions, the potential for future impact on commercializing the idea may be a factor, including the background and experience that each person brings with them.

How Should Equity Be Apportioned Among Founders?

If three people jointly conceive of an idea that is based on a business model rather than a technology, it would not be unusual for them to split the company evenly at formation. However, if one person conceived the idea, wrote the business plan, and assembled the team, a split of 50, 25, and 25 percent might be more appropriate. In addition, it is often the case that when the business plan is based on a proprietary technology, the developer of the technology receives a significantly higher percentage of the company. However, if the technologist is fortunate to attract as a cofounder a CEO with established industry credentials and connections, that person’s business experience might level the playing field and suggest a more equal split of founders equity.

If you are the lead promoter of an idea and are faced with making the initial proposal regarding the division of equity, keep in mind that nibbling around the edges of a prospective cofounder’s equity position may not engender the level of trust and cohesiveness that is so essential among the members of a founding team. The objective is to reach an allocation that is perceived to be fair and that leaves all of the founders with proper incentives to do what is necessary to make the business a success.

Should Your Client Formalize Its Relationship with Its Advisors?

Every successful business is the result of input from a variety of sources and factors. Entrepreneurs typically have mentors or other influencers in their lives who contribute significantly—and sometimes regularly—to the direction of the enterprise. Often these are people who do want a formal relationship with the company, but whose name and/or experience lend strength to the company’s management team. This connection can be particularly helpful when the founders are relatively inexperienced. The formation and use of a board of advisors is a great way to formalize advisor relationships, acknowledge the contributions such advisors make to the success of the business, and bolster the strength of the company’s management team without subjecting the advisors to the responsibilities and liabilities of being a manager, officer, or director of the company.

What Are Owners Agreements, and What Should They Cover?

Contracts among business owners often take the form of a buy-sell agreement, shareholder agreement, stock restriction agreement, operating agreement, or partnership agreement, among others. This book contains several examples of owners agreements, which present sample provisions for a variety of circumstances owners may wish to cover regardless of the form of entity in which they do business, or even the existence of an entity. The desired provisions can be selected and combined from sample agreements included in chapters dealing with different entity types. Some important uses of such an agreement include:

Determining the relative contributions, duties, and responsibilities of the parties

Determining the relative rights, benefits, and returns of the parties

Establishing and protecting intellectual property rights

Addressing conflicts of interest, noncompetition, and protection of trade secrets

Restricting the transferability of ownership; providing rights of first refusal

Succession planning; buy-sell provisions

Employee incentives

Procedures for the valuation of the business

Preventing competitive activities or use of trade secrets

Deadlock and dispute resolution provisions

Defining applicable law, venue, and jurisdiction

A well-drafted buy-sell agreement will contain many additional provisions, such as the following:

Provisions relating to maintaining the status of an S corporation so that no shareholder can terminate its status

Provisions allowing stock to be transferred to family members or trusts for estate planning purposes

Provisions that transfers by operation of law (e.g., death or divorce) should trigger the right of the company and other shareholders to purchase the stock

Life insurance provisions, including allowing the company to purchase life insurance on the life of a shareholder, and the right of a shareholder to purchase the life insurance at its cash value upon termination of employment

Provisions that each shareholder’s stock certificate include a legend giving notice that the stock is subject to the provisions of a buy-sell agreement and that a copy of the same can be reviewed at the offices of the company

A carefully drafted buy-sell agreement will promote the goal of allowing the business to continue while fairly compensating a terminating owner.

The drafting of an owners agreement is also an excellent opportunity to assist your client with planning for potential discord among owners before a disagreement arises, potential changes in owner circumstances (such as termination of employment, disability, retirement, and death), and sharing ownership with employees. This should be a collaborative process, beginning with helping your client define its objectives for the agreement and getting time estimates for certain objectives (such as a liquidity event, retirement, etc.). Next, design an agreement that addresses the stated objectives and covers contingencies, giving careful consideration to an appropriate valuation procedure or formula. Once the agreement is finalized and signed, help your client identify appropriate times to revisit the agreement (e.g., when circumstances have changed in a way that makes a valuation method inappropriate or the client’s objectives have changed).

Revisit the agreement periodically!

Should a Small Business Impose Vesting Requirements?

A growing company will inevitably see employees come and go, and there may also be changes in the company’s ownership. However, many ownership changes can be avoided if vesting provisions are imposed. Typical vesting provisions require that an individual remain with the business for at least one year before being vested in any portion of equity ownership. This is referred to as a “one-year cliff,” typically involving 25 percent of the total, with the remainder vesting monthly over the next three years. One way to approach vesting is through a stock restriction agreement, which is an agreement among the shareholders of a corporation in which they agree to certain limitations on their shareholder rights. Stock restriction agreements are often used to ensure that stock issued to founders is properly “earned” by each founding stockholder, by imposing vesting provisions or giving the company the right to purchase shares held by a founder in the event the founder leaves the company within a certain period of time.

What Is a Section 83(b) Election?

Stock restriction agreements can have significant tax consequences. Unless the founder makes an election under Internal Revenue Code (IRC) Section 83(b) within thirty days after receiving shares subject to the restriction agreement, the founder is subject to tax. This is because the shares vest on the amount by which the value of the vested shares at the time they vest exceeds the amount paid by the founder for the vested shares. If the founder makes a Section 83(b) election upon receiving the shares, he or she is taxed, upon receiving the shares, on the amount by which the value of the shares at the time of receipt exceeds the amount paid for the shares. If it is expected that the founder’s shares will appreciate significantly in value, therefore, it may be a good idea to make a Section 83(b) election.

What Are Typical Vesting Requirements?

Five basic parameters need to be established in a typical stock restriction agreement with regard to vesting: (i) duration of vesting schedule; (ii) up-front vesting; (iii) cliff vesting; (iv) acceleration upon termination; and (v) acceleration upon change of control or initial public offering (IPO). Venture capitalists have established certain acceptable ranges for these parameters, and they serve as the best guide for determining what vesting should be self-imposed by the founders. By self-imposing restrictions before VC funding, the VCs might satisfy themselves that what is in place is acceptable; as a result, the founders may end up with slightly more favorable terms than they otherwise would receive from VCs on this point. The following are some general parameters, which tend to change over time due to the labor market and can vary by industry.

Founders stock generally vests over three years. It is fairly common in VC transactions for founders to have some percentage of their stock vested up front. VCs will often agree to this if a significant amount of effort was put into the company before funding. The range of up-front vesting typically falls between 10 and 25 percent.

Vesting is said to be on a “cliff” basis when a certain minimum period of time must elapse before any additional shares of stock vest. Six- and twelve-month cliff vesting is fairly common, with the current trend toward the shorter end of that range.

Any number of circumstances could lead to termination of the founder’s employment. VCs often take the position that the equity must be earned, and that if the founder leaves for any or no reason, no additional stock vests. There are four basic circumstances in which a founder might leave the company: (i) resignation (for no reason and for good reason), (ii) termination (for cause and without cause), (iii) death, and (iv) disability. In the event the employee resigns voluntarily or is terminated for cause, no additional stock vests under most agreements. However, an argument can be made that if the founder is terminated without cause, or resigns for good reason (in other words, is forced out), there should be some compensation to the founder out of fairness and as a means of keeping the board of directors honest. While VCs resist any acceleration under these circumstances, occasionally founders are able to negotiate for an acceleration of six to twelve months. In the event of a founder’s death or disability, six-month acceleration is fairly common, presumably as a good will gesture in a time of hardship.

VCs will generally permit either an additional one-year vesting or 50 percent vesting upon a change of control. A founder can make certain assumptions about when the change of control for the company would be most likely to occur and determine which of these two options appears most preferable. For example, if the vesting duration is three years, and the founders anticipate a sale of the business after year one, the founder would be better off with one-year acceleration because it would always result in more acceleration than would 50 percent after the first year.

Occasionally founders are able to obtain full acceleration upon change of control, and it is not always an unreasonable starting point for negotiation. After all, if the company is sold and the founders are still with the company, they likely made significant contributions to put the company in a position to be bought. VCs, however, are very reluctant to allow for full acceleration upon change of control. Their primary argument is that the value of the company diminishes if the founders stock vests fully upon change of control because the founders have less incentive to work for the acquirer after the acquisition. This is why some companies will not make deals with companies that provide for full acceleration upon change of control. What VCs are not as quick to tell founders is that they stand to benefit significantly if the founders stock does not vest upon a change of control, because their relative percentage of ownership determined at the time of the change of control increases to the extent that the founders’ percentages decrease. If the VCs do not permit for full acceleration, an alternative is to request that they agree to provide for full acceleration if the founder is let go or resigns for good reason within one year following a change of control.

How Should Ownership Be Valued for Purposes of a Buyout?

For purposes of buy-sell provisions, value can be determined by the market value (if there is a market for the company’s equity), appraised value, book value, a formula, mediation, or any number of other approaches and variations.

Conflicting interests will be at play, such as the desire to provide liquidity while preserving the company’s ability to continue in business. However, if the parties to an agreement are determining how value will be established for a buyout at a point when they do not know whether they will ultimately be on the buying or selling end of the bargain, the chosen approach is more likely to be fair than it would be if the parties were forced to resolve the issue after a need had arisen.

Sample Documents and Checklists.

This section includes the following forms:

Founders Agreement (Form 9 A)

Shareholder Agreement (Form 9 B)

Provision to Deal with Phantom Income (Form 9 C)

Insurance-Funded Buyout Provision (Form 9 D)

Bylaws for a Board of Advisors (Form 9 E)

Board of Advisors Agreement (Form 9 F)

Form 9 A: Founders Agreement

Note: The following is an example of a fairly simple agreement between the founders of a new business before its incorporation. A more detailed agreement may be desirable and could continue to govern the relationship after incorporation as a shareholder agreement. See the sample owners agreements in Chapter 10 for examples of more detailed provisions that could be adopted by founders. In the event the corporation is never formed and a dispute arises between the founders, the rules of partnership would likely be applied. However, an agreement such as the following can be useful in preventing the application of default rules to certain matters where the parties reached an agreement, thereby avoiding an undesirable result as well as preventing faulty memories from perpetuating the dispute.

FOUNDERS AGREEMENT

This agreement is made between ______________________ (Founder A) and ____________________ (Founder B) for the purpose of forming a [California] corporation called *******, Inc., hereafter referred to as the Corporation. Founder A agrees to contribute the assets described in Exhibit A attached hereto, collectively valued at __________________ Dollars ($____________) in exchange for a fifty percent (50%) ownership of the Corporation to be formed. Founder B agrees to contribute _________________ Dollars ($_____________) in cash in exchange for a fifty percent (50%) ownership in the Corporation.

Founder A and Founder B further agree as follows:

1. INCOME AND EXPENSES. The income and expenses of the Corporation will be allocated between Founder A and Founder B on a fifty-fifty basis until the Corporation has achieved aggregate sales in the amount of one million dollars ($1,000,000.00). Upon the one million dollar mark, the Corporation will begin making preferred payments to Founder A in the amount of not less than two percent (2%) per year of sales until fifty thousand dollars ($50,000.00) has been paid to Founder A as compensation for his early efforts on behalf of the business of the Corporation.

2. ASSETS & LIABILITIES. All assets and liabilities of the Corporation will be allocated between Founder A and Founder B on a fifty-fifty basis unless otherwise noted in this agreement.

3. MANAGEMENT DUTIES AND RESTRICTIONS. Founder A and Founder B shall have equal rights in the management of the Corporation. Neither Founder A nor Founder B may borrow or lend money, or make, deliver, or accept any commercial paper, or execute any mortgage, security agreement, bond, or lease, or purchase or contract to purchase, or sell or contract to sell any property or assets of the Corporation or their individual interest in the Corporation without the other’s consent.

4. BANKING. Founder A and Founder B shall deposit all funds of the Corporation in its name in such checking account or accounts as designated. All withdrawals therefrom are to be made upon checks or wire transfers signed or endorsed by Founder A, Founder B or an appointed agent acting on the Corporation’s behalf.

5. BOOKS. The books and accounting records of the Corporation shall be maintained and kept at the principal business location of the Corporation. The accounting records shall be kept on a cash basis and the fiscal year of the Corporation will end on December 31. The accounting records shall be closed and balanced at the end of each fiscal year.

6. SALE OF THE CORPORATION OR ASSETS. If Founder A and Founder B decide to sell the Corporation or any of the assets of the Corporation, other than furniture, fixtures and office equipment, the proceeds from the sale of the Corporation or the Corporation’s assets will be distributed in the following way: all outstanding debts and liabilities of the Corporation will be paid before any other distribution is made. Once all debts and liabilities of the Corporation are paid, the Corporation will distribute to Founder A an amount equal to the difference between what has already been paid to Founder A under paragraph 1 and the fifty thousand dollars ($50,000.00) agreed upon in paragraph 1 of this Agreement. The remaining proceeds, if any, will be split equally between Founder A and Founder B.

The furniture, fixtures and office equipment of the Corporation is subject to sale only upon Founder A or Founder B’s consent. In addition, Founder A or Founder B has the right to purchase all or a portion of the assets from the Corporation at a fair market price. If a fair market price can not be agreed upon, the Corporation can hire an agreed upon third party to set the price of the sale.

7. DISOLUTION OF THE CORPORATION. If both Founder A and Founder B elect to dissolve the Corporation, Founder A and Founder B shall proceed with reasonable promptness to liquidate the assets of the Corporation. The furniture, fixtures and office equipment of the Corporation is subject to sale only upon Founder A or Founder B’s consent. In addition, Founder A or Founder B has the right to purchase all or a portion of the assets from the Corporation at a fair market price. If a fair market price can not be agreed upon, the Corporation can hire an agreed upon third party to set the price of the sale.

8. BUYOUT. Founder A or Founder B may elect to sell their shares in the Corporation to the other for an agreed upon price. If an amount can not be agreed upon, the Corporation will hire an agreed upon third party to set the price of the sale.

9. DEATH. Upon the death of either Founder A or Founder B, the surviving owner may allow either Founder A’s spouse or Founder B’s spouse the right to step into the deceased shareholder’s shoes and have all the rights and privileges of the deceased shareholder. If the surviving shareholder does not allow this to happen, the Corporation will be dissolved according to paragraph 7 of this Agreement. The proceeds from the liquidation of the Corporation otherwise payable to the deceased shareholder will go to whoever has been designated by either such deceased shareholder to receive the proceeds of the liquidation in the event of his or her death.

10. ARBITRATION. Any controversy or claim arising out of or relating to this Agreement, or the breach hereof, shall be settled by arbitration, in accordance with the rules of the American Arbitration Association, and judgment upon the award rendered may be entered in any court having jurisdiction thereof.

In witness whereof the parties have signed this Agreement. The laws of _________ shall govern any dispute arising under or relating to this Agreement. Executed this ________day of ______________________, 20___ in [San Francisco, California].